A Currency Board was One out of Many Options of Monetary Policy

Mr. Gitanas Nauseda is considered to be among the most vehement opponents of the currency board system. When this reform was piloted through the Government and the Parliament, Mr. Nauseda worked at the Financial Institutions Division of the Bank of Lithuania and voiced his opinion in one of the leading national dailies, Lietuvos rytas. Let us take a look at how the story of the currency board is viewed by its opponent after ten years…

“I am against gold fetishism, against unseen passiveness which people display by consciously refusing to control the money they themselves print and by shifting responsibility to the unfeeling international gold standard.” These are not my thoughts. These are Keynes’ thoughts laid down in his early book “A Tract on Monetary Reform.” However, I would sign under these words without reservations. It does not matter that they refer not to the present-day currency board but to the gold standard. After all, differences between these two are only minor.
It is somewhat strange to see people believe that money – the creation of their own hands and mind – can best be governed only by economic laws independent of their will and consciousness. It is my opinion that the best solution is to entrust money to specialists who are good at economic laws and at the same time to shield the central bank from political interference by law. A model like this existed in Germany for many decades. It has been successfully applied in the United States. Today no one in the United States would even consider seriously whether it would be better to have A. Greenspan (together with his team capable of smelling an economic recession before it actually starts) or automatic rules of the game. Naturally, small countries have fewer options because they need to pay heed one way or another to strong world currencies. But even in this case there are always several alternatives.
In order to answer the question whether a currency board was the most suitable arrangement for Lithuania in the past decade, we would need to test other variants in practice. Unfortunately, this is not possible. For example, the central bank of Latvia under Repse’s leadership has performed no worse than our currency board. But this does not mean that in similar circumstances Lithuania would have succeeded in pursuing just as an effective monetary policy. It is not only the central bank’s governor but also a host of other factors all of which cannot be evaluated a priori that determine success.
It has never been my opinion that there is only one optimal choice of monetary policy, while all others are bad. Much depends not so much on monetary policy per se, but on the combination of monetary and fiscal policies (as well as other components of economic policy). In this respect monetary policy decisions can be divided into very good, good, satisfactory, bad and very bad. Although at first I was sceptical about currency boards, I think it would be simply unfair to label them as either bad solutions or very good solutions.
The currency board as a special monetary system has played no small part in stabilizing the Lithuanian economy. Two or three years after the currency board had been installed inflation and nominal interest rates fell down markedly. In addition to that, the currency board has proved to be a fairly good safeguard against the government’s expansionary financial policy. Under a floating exchange rate regime, fiscal policy errors frequently go unnoticed as a reduced exchange rate of the national currency against foreign currencies can always be blamed on improper decisions of the central bank. Under a fixed exchange rate arrangement (under a currency board system) an overly generous fiscal policy causes a loss of official foreign reserves and an increase in interest rates. When budget expenditures and borrowing needs on the domestic market grow and there is no possibility to borrow directly from the central bank, the state is forced to seek private creditors (banks, insurance companies, etc.) who would agree to extend more expensive loans. In extreme cases voluntarism in financial policy may “bar” the central market to the state altogether and put the state on the edge of a financial crisis. We faced a situation like this in the second half of 1999, and later on this experience taught our politicians a good lesson not to repeat past mistakes.
By denying the central bank the power of discretionary regulation of money supply and interest rates, the currency board made the central bank an improper target of political pressure. Indeed, how could the Parliament or the Government force the central bank to cut down interest rates or to “correct” the exchange rate or to extend a loan to finance a budget deficit if the central bank did not have a right to do so? Lithuanian politicians mechanically kept attacking the Bank of Lithuania with various requirements with the view to gaining short-term political dividends (for example, Prime Minister Gediminas Vagnorius advocated the idea of using official foreign reserves to stimulate domestic crediting), but after several years they perceived the futility of such efforts.
On the other hand, life has shown that a currency board can neither protect the banking system from upheavals nor be a kind of a substitute for the supervision of credit institutions. Quite the contrary. An effective and rigid supervision of a banking system is essential for a successful performance of a currency board. At the turn of 1996 inadequate control of credit institutions (both legitimate and illegitimate) provoked a banking crisis during which restrictions imposed by the currency board proved to be completely ineffective in putting out “the fire.” This forced the authorities to violate the principles of a “pure” currency board and to temporarily change the rules of the game, i. e. to revoke sanctions applied to commercial banks for non-compliance with mandatory reserve requirements, to provide liquidity injections for some of them and the like.
I think pegging the litas to the US dollar and not the German mark, as Estonia did, on 1 April 1994 was a mistake. The advocates of the currency board chose a passive approach, instead of a pro-active one, towards the choice of the anchor currency. They took into account the then obviously dollarised foreign trade and composition of loans, deposits and the currency market. On the one hand, this reduced the economy’s vulnerability to fluctuations in the exchange rate. On the other hand, it “conserved” a high degree of dollarisation for a long time. Later Lithuania’s integration into the European Union led the authorities to break the “conservative” currency board system and to re-peg the litas to the euro at the beginning of 2002. For subjective reasons, i.e. by pegging the litas to the euro at the time when the euro’s exchange rate was particularly low in relation to the US dollar, this re-pegging was financially very painful for the country’s inert deposit holders who continued to keep their deposits in US dollars and suffered tremendous losses.
When I think about the currency board’s mission and Lithuania’s upcoming membership of the European Union and the European Monetary Union, I recall an old maxim “the Moor has done his job, the Moor can go.” We intend to join the EU common currency space which champions discretionary monetary policy and an active central bank. There is some merit of the currency board in that Lithuania stands out from among Central and Eastern European countries as fairly well-prepared for financial integration. Unlike for many other acceding countries, for Lithuanian business a fixed exchange rate is not a new status quo but a customary and familiar condition of doing business.